The IRS and Real Estate
My dealings with tax authorities:
I am not a CPA, attorney or enrolled agent, but my thanks goes out to those who are. I used these professionals in the tax matters that I’ll describe below. It is with their invaluable guidance that any successes were achieved. Like Grandma always said: “Give credit where credit is due”.
Audits of tax returns:
The companies I have formed around land development projects have been audited five times by the Internal Revenue Service. I have been personally audited by the IRS one time. That’s six and counting for the Feds.
The rumor for years has been that the IRS targets the real estate industry. I have no idea if that is true but I do know that my five separate land development company audits happened in the span of nine years. For a while I was beginning to think that I was becoming a preferred customer. I would get the letters informing me that the company’s XXXX year tax return had been selected for “examination”. Examination being the IRS super duper secret code word for… AUDIT !!!.
For a while I had a perfect record. All company audits resulted in zero underpayments or penalties and none of the companies were audited more than once, or for more than a single year. On my personal IRS audit I wound up paying the Department Of The Treasury $900 and change on the recommendation of my CPA (“…not worth the hassle”) he said.
Oh well… my record currently stands at 5 & 1 on audits, with $900+ surrendered for underpayments and penalties.
Multiple tax authorities - multiple issues:
A few years back I was spoken to by a person close to me regarding a very serious tax matter. It was a recently widowed woman with multiple IRS and California Franchise Tax Board problems.
The first part was an Innocent Spouse claim (IRS Form 8857). This was for multiple years of federal and state tax underpayments and/or failure to file by the estranged husband who had just died. This was all unknown to the wife since they had been legally separated for years and had lived apart.
Later, there was also a demand letter to file a California Tax Return as a result of a lawsuit settlement payment in her favor. She had not resided in California for over 2 years, so was she was not tax obligated…but they sure tried hard.
In the end, all issues with both taxing authorities were fully resolved with no underpayments or penalties for the wife and she was fully released from the tax liability exposure her husband caused. That took 5 years for full resolution.
One more:
Acting as durable power of attorney and later as the estate executor, I dealt with the California Franchise Tax Board regarding residency status for income tax purposes for of one of my land development investors, who also died midway through. The whole thing went on and off for five consecutive years. Because he was very wealthy, they tried hard to pin him as a resident for multiple year income tax filings, but he was not a California resident. That argument was eventually won too.
Sometimes it feels like I’ve been around the world once and twice backwards with taxing authorities. I wasn’t alone since CPA’s and tax attorneys went along for the ride in each case. Their advisement was not only effective with the tax situations, but also very instructive for me. You can learn a lot by going through adversity.
With that much involvement with the IRS and state tax boards you might think I would have a bad attitude toward them. Not really, because the key to staying clean for me (and what I’ve observed with the others described above) is as follows:
Keep clean accurate books.
Retain organized tax records.
Follow accepted bookkeeping principals.
Do not ignore a communication.
Respond promptly.
Never lie.
Many audits today are computer generated and examined, but I believe the same principals apply whether it’s an in-person examination or digital.
Frankly it’s not that hard, but it sure took a lot of time to resolve all of the above issues since nothing ever seems to move quickly.
Time to prepare for audits:
It didn’t take as much time as I thought it would to prepare for my land development company audits. Credit goes to my one and only employee who also kept the books. She was a jack of all trades and did a great job. She could pull up anything on QuickBooks in the blink of an eye. Proof of the quality and accuracy of her work were the audit results and how quickly the federal examiners “left the building”.
My opinion is that careful preparation is a key component of establishing credibility with the examiner. They have the tax return already, so an audit is mostly a process of substantiating the line items in the tax return and the supporting schedules and looking for errors, omissions and full compliance. That, along with virtually anything else they want to see.
My actual experience is as follows: - To the extent that the supporting evidence is provided promptly, completely and accurately, the examiner realizes that the taxpayer is organized. To the extent the examiner can verify the accuracy and completeness of the information provided, the taxpayer is good. To the extent they find nothing to gripe about, the taxpayer is home free. That’s my experience anyway.
I love my bookkeeper:
In my first year in land development I used an outsourced bookkeeper. She was actually a CPA but needed to have an at-home / part-time work life, so she opened a bookkeeping business. After hiring my employee I decided to have her do the QuickBooks entries, so I sat down to go over the program with her. It wasn’t long before she was a full blown QuickBooks expert and it was much more convenient because she was close at hand and working exclusively on my stuff.
It was sweet because all I had to do was ask a question and the answer was there! Plus, it was right every time! I’ve had a really good experience with my two bookkeepers and given the fact that I had multiple corporations, LLC’s and trusts related to my land development projects, there was a constant stream of bookkeeping work to do.
Aggressive enforcement:
The IRS’s job is to collect every tax penny due, along with any penalties and interest, - not one cent more. I have seen the aggressive side of the IRS with the widowed woman I mentioned before. The case had been escalated over the years and an active enforcement stance had been taken. Because my friends know I have dealt with lawyers and tax experts for years, I was asked by her to read the letters.
Once I finished I recommended and immediately found a tax attorney and a CPA with her ok. As a non-paid friend voluntarily coordinating the tax professionals in this disagreeable process, it became very apparent to me that it is a big sin with tax authorities to ignore their communications. It can and does breed heightened and eventually forceful aggression!
State tax boards:
I’ve dealt with 3 state tax boards - Utah, Arizona and California. I have a visualization about baseball that describes my experiences - Think of power hitters in baseball and then imagine the states that assess income taxes as the power hitting lineup. Batting in the clean up spot and the Babe Ruth of all of them is the California Franchise Tax Board. They swing for the fences every time!
All of the state tax boards are tied into the IRS database so it isn’t hard for their computers to see what and how a taxpayer’s information is being reported at the federal level. It’s just as easy for them to see if a taxpayer is failing to file with the state, or if what they are filing differs from the federal tax return.
Another challenge I faced with the California Franchise Tax Board centered around a California home that my investor owned, but he actually lived full-time in another state. After my investor died and I became the executor of his estate I would regularly receive demand letters from California to file income tax returns. This was on-going for every tax year that he had owned the California property and it took me 5 solid years to get them off my back.
I am not sure if this is still the case, but back then if a person stayed in the state for 180 days or longer during the tax year, that person was considered a resident for California income tax purposes. There was also no statute of limitations on how far back California could go for examinations; unlike the IRS where individuals are free after a certain statutory period, as long as it isn’t tax fraud or other illegal activity.
I would receive California’s demand letters, then dutifully call them and start defending his true full-time residence. My experience with taxing authorities is along the lines of “guilty until proven innocent”. Therefore, I needed to prove to California that his full time residence had been elsewhere. This involved everything from producing his home phone and utility bills, the address on his passport and driver license, voter registration etc.
It worked every time, but then with each new tax year a new demand letter came, followed by more demand letters for the past years that were supposedly already resolved. In the end, since he had been deceased for a while, I had no current records to produce so I again sent them his death certificate, my communications and documentation from years past, and politely asked them to please stop. Somehow that worked… finally.
Taxing authorities can make mistakes:
With over 2000 pages in the federal tax code and millions of “customers” the IRS (and states) can make mistakes. Here’s some that have happened to me over the years:
Properly submitted federal estimated quarterly tax payment not credited, but later found.
Error on federal tax refund amount.
Failure to recognize a Form 4868 automatic individual tax return extension that was correctly filed (for 2 years in a row).
Demand to file a state tax return that had already been correctly filed on time.
Accrued penalties and interest for a supposed late tax return payment that was actually cleared by my bank before the payment was due.
These examples were minor issues that were fixed pretty easily, but no one wants to get tax related mail since it’s never very friendly.
It’s also very annoying and time consuming. This is why the accuracy, organization and retention of tax records is important. Even when they made mistakes I still had to prove they were wrong and proof requires clear evidence. Likewise with the audits.
Going forward:
Between the audits and other examples given I have spent a fair amount of time dealing with tax issues outside of standard filings. Unlike some folks I don’t carry resentments for the taxing authorities, they are just doing their job. After all, if I walked around with an attitude about it, nobody at the IRS or the state tax boards would give a damn anyway, so the only one being bothered about it would be me.
On my first audit I was really torqued up, but as I went through all these different experiences it finally dawned on me that the companies, trusts and me personally were doing a pretty darn good job of financial management and reporting. I also experienced at a safe distance what happens when tax obligations are not managed properly.
CPA’s, tax attorneys and enrolled agents have been the key to successful outcomes for me. I never hesitated to use them to help understand and deal with the issues I have described. I truly believe that if anyone, including those in real estate, fulfill their tax reporting and payment obligations in an accurate and timely way there is nothing to fear. Then, if audits happen or documentation is required on a particular issue, it is there as needed. Good luck and be diligent!
Contact me at: ldr@landdevelopmentrealities.com
Blog photos courtesy of Unsplash.com and freeimages.com - Thank you!
